In defence of the golden parachute

An offer of a golden parachute is sometimes necessary for firms to attract the best executives

Remuneration is back in the press, with proposals to make shareholder votes binding. Though the latest proposals aren't specifically about the pay of bankers, it's pretty clear that it is banker remuneration that most irks the public. People feel that bankers earned a lot of money as a reward for losing a lot of money and bankrupting banks that the taxpayer then bailed out, and that somehow this has been permitted to continue even though the government now owns the banks.

Well, in the banking sector there are particular issues around remuneration. In particular, the greater the level of government insurance of depositors, the higher will be the average level of banker pay (see p39 here - but essentially what happens is that if the government bails out depositors, then bankers become like monopolists once banks have made loans, and extract "rents"), and if the government bails out bondholders as well, then bank staff will have bonus schemes that encourage excessive risk-taking (explained here from p23ff).

But are there issues about remuneration that go wider? For example, are there problems in large non-bank companies – e.g. with the remuneration of FTSE executives? Obviously FTSE executives get paid quite a lot of money, but so do footballers and pop stars. Are FTSE executives really so much less worthy recipients of their pay?

A common suggestion is that they must be, because the pay of executives has risen in recent years, even though share prices have not. The thought, then, is that pay rises for executives have been unrelated to performance. That doesn't actually follow, of course. Just because share prices fall that doesn't mean the boss has been doing badly – it might be that having a good executive means that share prices fall by less than would happen otherwise. As an analogy, suppose that a football team loses 1-0. Does that mean the goalkeeper played badly? Obviously not – we've all seen matches where the goalkeeper played brilliantly in defeat, and it was only because of his excellent performance that the score was 1-0 instead of 5-0.

Indeed, it is perfectly plausible that, rather like a goalkeeper, an executive's skill is tested much more in hard times than in good. In other words, an executive might add much more value to a company (relative to the large falls that might occur otherwise) in a bad period than in a good period, when all the executive might have to do is to keep things ticking over. There's not actually much reason to believe that share prices across the economy falling means that executives have all been producing poor performances.

But what about the notorious "golden parachute" schemes, in which executives get paid for being fired? Well, these actually perform quite important economic functions, and it would be a grave error to outlaw them. A fuller discussion can be found here, p31ff, but the key insight can be obtained by reflecting upon the original scheme described as a "Golden Parachute". In 1961, Charles Carpenter Tillinghast Jr was recruited, from a job he held as a Vice President of Bendix, to become the President and CEO of Trans World Airlines (TWA). He was hired to TWA by a group of TWA's creditors who were at the time involved in a bitter legal dispute with Howard Hughes, who had been in control of the airline up to then and whom they were attempting to supplant. As the creature of these creditors, it seemed almost certain that, if Hughes were to win the legal dispute, then Tillinghast would lose his job. So if Tillinghast were to give up his perfectly good job at Bendix for the high-risk role at TWA, he needed some re-assurance that if he were suddenly to be dismissed, he would not be ruined. His contract therefore contained provisions for payments to him in the event of his dismissal. Playing on the aviation theme, Tillinghast's contract was described as a "golden parachute" scheme.

This reflects a more general issue. When executives are recruited into difficult situations, which sometimes might involve restructuring and assaults on vested interests within the firm, there will sometimes be a high probability that the support of the board will drain away before the executive's reform programme is complete, and the executive will be fired – not because she has failed, but because she is ruffling feathers by doing precisely what she was hired to do. "Success" for such a reform programme will not often be measurable in terms of profitability – the executive might well be trying to turn around loss-making divisions and they might well be still loss-making at the point board patience evaporates. So to induce high-quality people to give up safer jobs for such high-risk turnaround enterprises, guarantees must be offered – golden parachutes. If firms don't offer them, then (a) they won't get the best people; and (b) boards are less likely to stick the course.

What about the huge differentials between salaries at the top and the rest (discussed here, p33ff)? Differentials can be quite high, but research suggests that those in the UK are not notably higher than in, say, Germany or France. This contrasts with enormously higher differentials in the US. If shareholders want to pay executives much more than shop floor workers, isn't that for the Market to decide?

That brings us to the nub of the current debate. The government might be seeking to signal its empathy with the sorts of concerns we've discussed above. But in fact its only concrete proposal at this stage is to make votes on director remuneration by sharedholders binding, as opposed to advisory. Well, that's not an especially new idea – that shareholder votes should be binding is the default position envisaged in UK company law as far back as the Companies Act 1862. And there is nothing to prevent companies from having binding votes now. What happened over time, however, was that for more and more companies (especially large companies) shareholders delegated the task of setting remuneration for directors to…directors. Well, that might seem problematic, but of course shareholders can still dismiss directors. So if shareholders thought directors paid themselves too much they could (a) take back the power to set director remuneration; and/or (b) fire the directors.

Up to now they haven't done this much. Of course, market forces may mean that they do in the future. Is there really a role for government here? Perhaps making shareholder votes always binding is relatively harmless – reflecting old practice. But is it really necessary?